Reason Foundation

John Taylor and the Need to Limit Fed Discretion

John Taylor, Stanford economist and creator of the nominal interest rate rule which bears his name, recently testified before the Joint Economic Committee discussing the merits of the newly introduced Sound Dollar Act. An op-ed published yesterday in the Wall Street Journal highlights his thoughts on the new legislation and on the necessity to curb ad-hoc monetary policy as currently practiced by the Federal Reserve under Ben Bernanke.

The Sound Dollar Act, if passed, would require the Federal Reserve to operate with a single mandate of long-term price stability instead of its current “dual mandate” which requires the Fed to promote price stability and maximum employment. The Act would also limit Federal Reserve purchases to Treasuries (except in emergencies), and give voting rights to all Federal Reserve district presidents at every Federal Open Market Committee meeting. Currently, voting rights are designated on a rotating basis to just four of the regional presidents, and the Fed is authorized to purchase anything it deems necessary, and in any quantity.

Critics of the Federal Reserve, and there are many, argue for a variety of reforms ranging from the return to a gold standard to competitive currencies to merely mild policy changes. Although an oversimplification, the main complaint currently is the uncertainty created by the Fed and Bernanke. Clearly there are numerous ways to solve this problem given the plethora of reform options on the table, but all seek to accomplish the same ends. That is holding Federal Reserve policy to an objective standard, and limiting the discretion of those entrusted with conducting monetary policy. Under a gold standard these are both accomplished through the limits of the commodity. Similarly in a competitive currencies market, the market itself accomplishes these goals. Of the policy reforms put forth, some are better than others, but again all more or less attempt to establish an objective standard and limit Fed discretion but without the headaches and general inconceivable nature of a gold standard or the elimination of the central bank.

Taylor’s testimony, contributions to economics and recent track record argue for the implementation of the Sound Dollar Act. By requiring the Fed to abide by a single mandate of price stability and limiting their open market operations to just Treasuries, the Fed is held to an objective standard and the discretion by which to conduct policy is limited to a single avenue of Treasury sales and purchases and interest rate adjustments.

This reform is not radical like those touting the merits of a gold standard, yet it accomplishes the same goals. It also would allow for a much more smooth transition period and maintain the ability of the United States to conduct monetary policy, but now one that is predictable and that actually promotes maintaining the purchasing power of the dollar, rather than pursuing its decline.